Active managers bite back
Although it’s a survey on those providing passive management it’s interesting to look at some of the reasons given for not providing passive management. Some institutions take the attitude that they never have provided it, never will. Others elaborate as to why they prefer to concentrate on active management.
Many managers cite market inefficiency as an explanation for using active management. Fiduciary Trust believes there are sufficient variables affecting security prices to enable active managers to outperform indexed portfolios. AIG is another. “We believe that markets are inefficient and that research-based and therefore informed human judgement can exploit this inefficiency,” it says.
According to JP Morgan Investment Management, efficient markets should mean active strategies are unable to beat the market on a risk-adjusted basis. “However, reality often falls short of this ideal. Empirical evidence illustrates that the stock market can be beaten,” it says. JP Morgan says shifting fundamentals give active managers the opportunity to add value by better understanding the implications of new information. “When markets are in transition and structural changes are occurring, experienced analysts may form more accurate expectations,” it says.
It admits there are years when an active manager will underperform but that on a three- to five-year average its active management will add value. That is, given a few provisos – active managers should set an excess return target and an acceptable level of risk.
The group adds: “Our goal as an active manager is to control the risk of underperforming the market while generating consistent excess returns.”
Fiduciary Trust also stresses risk as a reason for pursuing active management. “We focus not only on return enhancement but also on risk reduction or at least proportionate return for the risk taken. By its very nature indexing portfolios means that it is simply not possible to reduce risk proportionally to the returns. We are able to achieve greater returns with a reduced level of risk,” it says.
Aberdeen says passive runs against its investment strategy: “While we recognise that passive management has some attraction in minimising transactions and associated costs, we believe that we have the ability through our asset allocation and stock selection process to outperform passive mandates, even after costs.”
Capital International is convinced passive mandates underperform for numerous reasons. Indices exclude dealing costs incurred in private management and assume dividends are reinvested when declared (in practice not always the case). Indices assume full recovery of withholding taxes which in practice may only be partially recoverable over several months. Finally, it believes indexed portfolios are partially liquid for trading purposes whereas an index has no cash component. Inaccurate divisors are also used for performance measurement, it says.
Others are more forthright. For example, Bank Sarasin says: “We believe investing in indexed funds is buying a group of has-beens and is effectively institutionalising a buy high/sell low investment strategy. At Sarasin we add value through active management, investing thematically.”